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National Institute of Economic and Social Research

Sunday, 9 December 2012

Indexing benefits to inflation is not "unsustainable"

In the Autumn Statement the Chancellor decided to cut working age benefits and tax credits, thus reversing his previous (sensible) policy of allowing the "automatic stabilisers" to operate, and ignoring the advice of the IMF. More on the macroeconomic issues here. He justified this change thus:

But we have to acknowledge that over the last
five years those on out of work benefits have seen their incomes rise twice as
fast as those in work. With pay
restraint in businesses and government, average earnings have risen by around
10% since 2007. Out of work
benefits have gone up by around 20%.

That’s not fair to working people who pay the taxes that fund them. Those working in the public services, who have seen their basic pay frozen, will now see it rise by an average of 1%. A similar approach of a 1% rise should apply to those in receipt of benefits. That’s fair and it will ensure that we have a welfare system that Britain can afford.

David Smith, writing in the Sunday Times, repeated the Chancellor's argument verbatim and stated that:

"In five years, out of work benefits have risen 20%, earnings 10%. That is unsustainable.."

The numbers are correct: but they are highly selective, and David's conclusion is simply wrong. The value of out of work benefits relative to average earnings (and more broadly the incomes of those in work) has fallen steadily over the past three decades, until the recent slight uptick resulting from the recession:

In 1979, unemployment benefit (the predecessor to Jobseekers' Allowance) was about 22% of average weekly earnings; today it's about 15%, a relative decline of about a third. What's going on? Simple: JSA has been indexed to inflation. In normal times, earnings rise faster than prices, as workers become more productive and the economy grows; this chart shows the cash value of both JSA and average weekly earnings:

So indexing benefits to prices has been far from unsustainable, or "unfair" to working people, over the last 30 years. Indeed it has resulted in a substantial reduction in spending on out of work benefits as a proportion of GDP, compared to the alternative of indexing benefits to earnings. As a result, we already have "a welfare system that Britain can afford", at least for those of working age. Declan Gaffney et al note (table 3) that all out-of-work benefit spending only amounts to some 3 percent of GDP. And even overall benefit spending, which has to accommodate the growing number of pensioners, has levelled off, as Chris Dillow has pointed out. There is nothing remotely unsustainable about any of this.

In the last five years, however, earnings have risen much more slowly than prices, as the Chancellor points out. This is highly unlikely to persist, however, and it is certainly not what the official figures suggest: the Office of Budget Responsibility's forecast, which is not particularly optimistic about growth over the near term, suggests that earnings will rise about 5% faster than prices over the forecast period (table 1.1). So unless we are stuck in permanent depression, even a modest recovery will in time lead to earnings rising significantly faster than prices, and the relative value of out of work benefits will decline again. No policy action is required to ensure this (although economic recovery would help!).

So unless the OBR is completely wrong, and the economy flatlines for the foreseeable future, with no or negative growth in earnings relative to prices (and even at my most pessimistic I don't think that's likely) then the idea that benefits need to be cut in real terms in order to ensure either fairness to those in work or long-term sustainability is nonsense.

Jonathon, Great article, but what makes you confident that the OBR have got their growth forecasts right this time? Where on earth is growth going to come form when Osbornes cuts are deepening, he has no growth plan and Europe is contracting and likely to get very messy?

'So unless the OBR is completely wrong, and the economy flatlines for the foreseeable future, 'Fiscal cliff, Chinese slowing down, India slowing down, EU highly unstable and GDP crashing there, middle east kicking off, tension between Japan and China, Brazil slowing down,broken western banking system, unbalenced western govt balence sheets and private sector that is maxed out on the credit card. It's not clear why things should get better. If we take just europe and the US i.e. over 40% of world GDP, just in the coming month we see the US facing a decision that will impact GLOBAL GDP. In europe, GDP is CRASHING in the last quarter...These are all facts. Should the NIESR be considering these events?

Jonathan, I assume you use the average earnings growth for all income categories. How does the graph look if you instead only use income growth for the bottom quintile? Given the relative stagnation of low income wage growth in the last few decades it seems likely that such a graph might not look so bad relatively for JSA claimants.

Not that I don't agree with you about maintaining economic stabilisers of course.